Economics

Private equity

The propaganda versus the facts

Sep 21st 2012, 16:55by M.C.K. | WASHINGTON

MITT ROMNEY has not been kind to the private equity industry. Before he emerged as a presidential contender, the buyout barons were contentedly earning fortunes magnified by quirks in the tax code. Thanks to him, they now are demonized as rapacious asset-strippers who hide their ill-gotten gains in secret bank accounts. Unsurprisingly, the moguls have decided to fight back with a public relations campaign titled “Private Equity at Work”. The propaganda is based on three ideas: PE creates jobs, PE increases productivity, and PE allocations boost the returns of public pension plans. The facts paint a muddier picture.

As it turns out, target-firm employment losses are much greater in public-to-private transactions than other private equity buyouts. Relative to controls, employment shrinks by 10% of initial employment in the first two years after private equity buyouts of publicly traded firms.

The second case is the strongest. The existing literature seems to suggest that, overall, PE ownership improves the productivity of takeover targets. One study looked at the number and quality of patents generated by firms owned by PE funds:

Our main finding is that firms pursue more influential innovations, as measured by patent citations, in the years following private equity investments. Firms display no deterioration in their research, as measured either by patent “originality” or “generality,” and the level of patenting does not appear to change after these transactions. We find some evidence that patent portfolios become more focused in the years after private equity investments. The increase in patent quality is greatest in the patent classes on which the firm has historically been focused and in the classes where the firm increases its patenting activity after the transaction. The patterns are robust to a variety of specifications and controls. Taken together, these findings are largely inconsistent with the hypothesis that private equity–backed firms sacrifice long-run investments. Rather, private equity investments appear to be associated with a beneficial refocusing of firms’ innovative portfolios.

The one robust predictor of LBO leverage we find is the prevailing condition of debt markets: the higher the credit risk premium of leveraged loans, measured as the high-yield spread over LIBOR, the lower the leverage used in the buyout transactions. As a consequence, leverage in the LBO deals is pro-cyclical, with leverage peaking during “hot” credit market conditions, such as in 2006-2007, and falling when debt markets deteriorate, such as in 2008-2009. In contrast to the procyclicality of buyout leverage, we find that a matched set of public firms exhibits countercyclical leverage.

We then examine whether the availability of leverage leads private equity funds to pay higher purchase price multiples for the firms they acquire. We find that this is indeed the case, with buyout pricing being strongly negatively related to current market interest rates on leveraged loans, even after controlling for pricing in public markets. We also show that the impact of debt markets conditions on buyout leverage and pricing holds in a time-series regression, controlling for a large set of macroeconomic variables, and using several alternative measures of debt market conditions…We estimate equations measuring the impact of leverage on fund returns. Contrary to the basic cost of capital prediction that, holding other factors constant, returns to equity should increase with leverage, we document that the leverage of the deals in a particular fund is negatively related to the return of that fund (measured relative to returns on public stock markets), controlling for other relevant factors. This finding is consistent with an agency story in which private equity funds overpay for deals at times when leverage is cheap.

As if all this were not bad enough, PE funds have one extremely undesirable property: their performance is negatively correlated to the amount of money allocated PE funds. Consider this study:

Prices paid for cash flow were generally higher at the end of the buyout waves than at the beginning. The more recent period, in particular, exhibits a great deal of cyclicality, first dipping substantially in the 2001 to 2003 period and then rising afterwards…We use capital committed to private equity funds in the vintage year and the previous vintage year relative to the total value of the U.S. stock market. Regressions 1 to 4 in table 3 indicate a strong negative relation between fundraising and subsequent vintage year returns. The inclusion of a time trend does not affect the results. While this simple regression finding can only be considered illustrative of broader patterns, it suggests that the inflow of capital into private equity funds in a given year can explain realized fund returns during the subsequent ten- to twelve year period when these funds are active. In particular, it strongly suggests that an influx of capital into private equity is associated with lower subsequent returns…Capital commitments are positively and significantly related to lagged private equity returns. I.e., investors seem to follow good returns. Second, the positive trend is consistent with significant secular growth in private equity fund commitments over time above any cyclical factors. To summarize the regressions, private equity fund returns tend to decline when more capital is committed to this asset class. Capital commitments to private equity tend to decline when realized returns decline. In other words, the patterns are consistent with a boom and bust cycle in private equity.

Unfortunately for the pension plans that have allocated money to PE funds, the paper also notes that more than half of all buyout deals since 1970 “had not yet been exited by November 2007.” Their conclusion is sobering:

What will happen to funds and transactions completed in the recent private equity boom of 2005 to mid-2007? It seems plausible that the ultimate returns to private equity funds raised during these years will prove disappointing because firms are unlikely to be able to exit the deals from this time period at valuations as high as the private equity firms paid to buy the firms. It is also plausible that some of the transactions undertaken during the boom were less driven by the potential of operating and governance improvements, and more driven by the availability of debt financing, which also implies that the returns on these deals will be disappointing.

While some of the charges against the private equity industry might be unfair, its practitioners should not defend themselves by pointing to the returns they have supposedly generated on behalf of public pensions.